Weak Inflation Not Surprise It Appears to Be, Cleveland Fed Says

If Federal Reserve officials have been surprised by the unexpected persistence of weak inflation, perhaps they shouldn’t be.

Cleveland Fed research released Friday argues that even as price pressures have managed to fall far short of central bank forecasts, central bankers haven’t necessarily made any fundamental mistakes as they’ve tried to predict the price pressure outlook.

“The unanticipated falloff in inflation should simply serve as a useful reminder of the uncertainty that always surrounds forecasts,” wrote bank economists Todd Clark and Saeed Zaman. They noted the missed forecasts “still fell well within a normal range of uncertainty” inherent to current forecasting methods. They added real world events played a big role as well: “Most of the deviation from the original forecast was a response to other economic developments.”

For some time now, Fed officials have been predicting that inflation will rise back to their official 2% target. September’s numbers were a black eye to that forecast. As measured by the overall personal consumption expenditures price index, prices were up 0.9% that month from a year ago, after rising by 1.1% in August. Stripped of food and energy, the core PCE price index was up 1.2% from September 2012. The report notes that in early 2012, policymakers expected inflation to be at 1.7% in 2013.

The Cleveland Fed researchers said that because the models still appear to work, there’s reason to be confident that things will ultimately play out as policymakers expect. “Our model projects that core PCE inflation has bottomed out and will gradually rise over time toward the FOMC’s long-term inflation goal of 2%,” Messrs. Clark and Zaman write.

Having adopted a 2% inflation target, Fed officials want to hit is square on. They consider price pressures above and below that mark equally unacceptable. In a speech Tuesday, Atlanta Fed President Dennis Lockhart said inflation is “too low” and explained “a persistent low rate of inflation raises concerns about a stalling out of economic expansion.”

Mr. Lockhart thinks inflation will rise back toward target over time, a view shared by most central bankers. That said, St. Louis Fed President James Bullard has said on a number of occasions Fed officials no longer have a good explanation for the persistence of weak price gains. Mr. Bullard’s concern about weak inflation drove the monetary policy setting Federal Open Market Committee to offer a more explicit commitment to defend its 2% target from both the high and low side at its July policy meeting.

Ongoing weak inflation also has implications for monetary policy. The Fed continues to pursue an $85 billion per month bond buying stimulus program, the fate of which is tied to the performance of the economy. Financial markets broadly believe the central bank will start cutting back on that effort at some point in coming months. But a case could be made that as long as the Fed is undershooting inflation, it should press forward with its easy money policies, as it tries to get inflation back to target.

Low levels of inflation have also caused some central bankers to reexamine their thinking about the extraordinary policies the Fed has pursed over recent years. For some time, Richmond Fed leader Jeffrey Lacker has warned one of the risks of the Fed’s massive balance sheet expansion was a sharp rise in inflation.

In a speech on Nov. 1, Mr. Lacker acknowledged he has, thus far, been wrong. He explained “given the expansion of our balance sheet, if you told me we were heading to a $4 trillion balance sheet, $4 trillion of outside money in the system, and that inflation expectations have remained stable, and apparently as a result inflation itself has remained remarkably stable, I wouldn’t have put 99% probability on that. I would have put much less probability on that.”

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